In order for its participants to receive favorable tax treatment, a “qualified” retirement plan must satisfy various requirements, including ensuring that it benefits a nondiscriminatory cross-section of employees rather than primarily benefitting highly compensated employees (HCEs). This is accomplished by requiring certain testing be performed relating to the number of employees eligible to participate in the plan, the number of employees who actually participate in the plan, and the amount of contributions or benefits provided under the plan to HCEs versus non-HCEs.
In proposed regulations issued last month (Proposed Regulations), the Internal Revenue Service (IRS) addressed the application of these testing requirements to certain types of qualified plans. Specifically, the Proposed Regulations relate to the application of the testing requirements when an employer maintains a “closed” plan or aggregates multiple qualified plans for nondiscrimination testing purposes. As defined in the Proposed Regulations, a closed plan is a defined benefit (DB) pension plan that has been amended to:
cease accruals under a benefit formula provided by the plan for some or all participants whose benefits were previously determined under that benefit formula; or
limit participation in the plan to a group of employees that consists of some or all of the plan participants who participated in the plan as of the closure date.
Over the past 15 years, many employers have moved away from offering retirement benefits under a DB plan and, as a result, an increasing number of such plans have been or will soon be closed. As the number of closed plans has increased, the nondiscrimination testing requirements have created some unintended consequences.
Although a DB plan may meet the testing requirements as of the closure date, once the participant population is frozen, ordinary demographic changes often result in the proportion of participants who are HCEs increasing over time. These demographic changes include (i) the pay of non-HCEs increasing over time such that they become HCEs; and (ii) the departure of more non-HCEs due to their increased likelihood of turnover. The Proposed Regulations provide a special testing rule for closed plans that meet certain requirements in order to account for this inevitable demographic shift.
If a closed plan cannot satisfy the testing requirements alone or through the use of the new special testing rule, another option for employers to consider when testing issues arise is to test the plan on an aggregated basis with a defined contribution (DC) plan also maintained by the employer. In order to replace the benefits that previously were offered under a closed plan, an employer often will adopt a DC plan to cover all employees who do not continue to accrue benefits under the closed plan.
In order to perform testing on an aggregated basis, accruals under the closed plan must be converted to equivalent contribution amounts or contributions under the DC plan must be converted to equivalent accruals such that the two plans are tested using the same measure of benefits. In general, it is typically easier to satisfy the nondiscrimination requirements if the employer converts contributions under the DC plan to equivalent accruals and the aggregated plan is tested based on the amount of accruals or equivalent accruals provided to employees. The Proposed Regulations address how to apply the nondiscrimination tests with an aggregated plan that consists of both a DB and a DC plan.
Special Testing Rule for Certain Benefits, Rights and Features of Closed Plans
As a part of the nondiscrimination testing, a plan must satisfy certain requirements to ensure that not only are contribution allocations and/or benefit accrual amounts nondiscriminatory, but also that all other benefits, rights and features of the plan (including optional distribution alternatives, ancillary health or life insurance benefits, availability of plan loans, the right to direct investments and the right to make rollover contributions) do not discriminatorily favor HCEs. The Proposed Regulations provide that for a plan that has been closed for five years or more, a benefit, right or feature is considered nondiscriminatory if:
it is available only to the participants that continued to accrue benefits under the plan after the closure; and
no plan amendment that affects the availability of the benefit, right or feature has been made effective since the closure date (except for certain permitted amendments).
In addition, a plan must meet certain requirements relating to the availability of the benefit, right or feature under a DB plan, and the rate of matching contributions under a DC plan, to take advantage of the special testing rule for closed plans.
Testing a DC Plan on the Basis of Benefit Accruals
In order to test a DC plan on the basis of benefit accruals (rather than contribution allocations), a plan must:
have broadly available allocation rates for a plan year;
have a gradual age or service schedule for a plan year; or
satisfy the “minimum aggregate allocation gateway” (Gateway) requirement under the IRS nondiscrimination regulations for a plan year.
When determining if a plan has broadly available allocation rates or a gradual age or service schedule for a plan year, “defined benefit replacement allocations” (DBRAs) are a special type of employer contribution that may be disregarded. The Proposed Regulations expand the definition of DBRAs to allow more allocations to qualify as DBRAs.
Under the Proposed Regulations, DBRAs are defined as allocations made under a DC plan that are designed to replace some or all of the benefits that would have been provided to an employee under a closed plan. To qualify as DBRAs, the allocations must be provided in a consistent manner to all similarly situated employees and the group of employees who receive a DBRA must be a nondiscriminatory group of employees for the first five years after the plan closes. In addition, the DB plan whose benefit accruals the DBRAs are designed to replace must have been in existence for at least five years before it closed and must have had no substantial amendments adopted during that time (except for certain permitted amendments). With limited exceptions, the calculation method for a DBRA may not be amended once adopted.
Application of Testing Requirements to an Aggregated Plan
In order to aggregate a DB plan and a DC plan and test them on the basis of benefit accruals, the aggregated plan must satisfy the Gateway requirement or qualify for an exception. The Proposed Regulations add a new exception from the Gateway requirement for an aggregated plan that included a DB plan that has been closed for at least five years. The exception applies only if the closed plan was in effect for at least five years prior to its closure and no significant amendments have been made to the plan since the date that is five years prior to its closure (except for certain permitted amendments). In addition, the closed plan must have satisfied specific nondiscrimination testing requirements during the first five years after its closure.
The Proposed Regulations also expand an employer’s ability to satisfy the Gateway requirement by allowing the use of average allocation rates for non-HCEs under the DC plan. The change is intended to accommodate plans that provide for service- or age-based allocation formulas by allowing employees with less service to have a lower allocation rate as long as the employees with more service are provided a high-enough allocation rate to maintain an acceptable Gateway rate. Also, the Proposed Regulations provide a “cap” under which any equivalent normal allocation rate in excess of a certain amount is treated as equal to such amount. This cap serves to minimize the impact of outliers.
Effective Date; Reliance by Plan Sponsors
The Proposed Regulations will take effect for plan years beginning on or after the date they are published in final form in the Federal Register. Before that date, for plan years beginning on or after Jan. 1, 2014, and until the final regulations take effect, plan sponsors can rely upon various provisions of the Proposed Regulations, including:
the disregard of certain DBRAs in nondiscrimination testing;
the exception from the Gateway as to certain closed plans; and
the special testing rule for benefits, rights and features as to certain closed plans.
The Proposed Regulations address highly technical nondiscrimination testing rules and are largely applicable only to employers that sponsor a closed plan or want to aggregate a DB plan and a DC plan for testing purposes. Such employers should discuss the impact of these Proposed Regulations on their nondiscrimination testing methods with their legal counsel and/or actuarial advisors.